Long Term Assets
Howe companies account for long term assets
Howe companies account for long term assets
Long term assets are assets that a company uses in its production process and typically come with a useful life of more than one year. Such assets can also be considered to be “fixed assets” as they can contribute to a big portion of the company’s fixed costs associated with production. For example, an automobile manufacturer might consider factories to be their long term assets since they are at the core of the business’ production process.
Regardless of the company’s monthly or yearly output, the costs associated with running the factories do not fluctuate greatly and represent a significant portion of the company’s cost of goods sold (COGS). Thus, these factories would be treated as the company’s long term assets. The assets also need to be depreciated over the course of their useful lives. In summary:
As with most types of assets, long term assets have to be depreciated over the course of their useful life. This is because a long-term asset is not expected to last the company an infinite amount of time. For example, in the automobile factory example, machines will become old and may experience breakdowns or fall victim to planned obsolescence.
There are many ways that a company can depreciate its assets, such as the double-declining balance method, the units of production method, or the straight-line depreciation method. It is important to note that depreciation is not a cash expense and thus does not represent an additional expense for the company.
Depreciation amounts that are incurred for the purposes of depreciating fixed assets provide a tax shield for the company’s income. Depreciation is subtracted from EBITDA before taxes are applied, and then the depreciation amount is added back after taxes have been subtracted. Thus, net income ends up benefiting and is overstated.
In order to better understand how long term assets affects a company’s financial health, it is important to become familiar with some terminology.
Property, plant and equipment (PP&E) refer to the long term assets that a company owns, and that are crucial to the production process. Property refers to any property or proprietary assets that the company employs in its production. Plant refers to the building and factories that are required for production. For instance, if a company decides to purchase the land atop ON which its factories reside, this land would be counted under the PP&E account. Equipment refers to machines and other production aids that a company utilizes in its manufacturing process. Generally speaking, the majority of the company’s long term (or fixed) assets fall under this category.
When a company acquires PP&E or other long term assets initially, it records the value of these assets at the time of purchase as the “book value” before accounting for depreciation. This number is usually equal to the market value of the respective long term assets that the company has purchased, and sometimes may be recorded as the purchase price that was paid by the company in order to acquire the asset.
Depending on the accounting framework that the companies follow, they may be able to choose between whichever values are the highest. Companies would want to pick the higher value since they would be able to depreciate the asset over a longer period of time, and thus experience greater tax benefits.
The carrying value of a long term asset (also called the net book value) refers to the current value of the asset on the company’s books. The number accounts for any depreciation that may have occurred. It can be thought of as an accurate estimate of what the company would be able to sell the asset off for right now.
Below is an example of what long term assets such as PP&E would look like on a company’s balance sheet:
As we can see here, Amazon’s PP&E account grew substantially from $29 billion in 2016 to $49 billion in 2017. This could be an indication that Amazon is pursuing capital-intensive projects and is investing in long term assets to sustain this expansion.
Long term assets are a crucial element of a company’s balance sheet and are required in order to accurately calculate the equivalent liabilities and shareholder’s equity. Below is a screenshot of CFI’s Balance Sheet Template:
To further understand the relationship between the various line items on a company’s balance sheet and how they relate to the company’s income and cash flow statements, check out CFI’s Accounting Fundamentals Course.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:
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